Report: 'End all swaps,' then ban them

The Bethlehem Area School District's use of risky derivatives, combined with a financial adviser who had a stake in making the deals and investment banks that made "huge hidden profits" once the deals were sealed, cost district taxpayers at least $10.2 million and possibly far more, a state audit report released Wednesday concludes.

Pennsylvania Auditor General Jack Wagner, at an Allentown news conference, said derivatives or "swaps" are so risky that the district, as well as every other local government or authority that has them, should end the deals immediately.

Wagner's office focused on Bethlehem, since it undertook more swap transactions than any other school district in Pennsylvania.

"It's almost as if the Bethlehem Area School District became the Bethlehem Sands casino in terms of the handling of public money," Wagner said.

He recommended repealing a state law that set standards for local governments to use the derivatives and that their future use by government agencies be prohibited.

State Sen. Lisa Boscola, D-Northampton, accompanied Wagner at the news conference and said she would introduce the legislation soon. She anticipated having bipartisan support.

According to the report, swaps are "highly risky and impenetrably complex transactions that, quite simply, amount to gambling with public money."

More than 200 school districts or other local governments in Pennsylvania have active swaps, Wagner said.

"The big picture is there is at-risk approximately $15 billion of taxpayer monies in Pennsylvania," Wagner said. "I am here today to say that must stop."

Bethlehem used swaps, which are private bets on interest rates with investment banks, to lower the cost of borrowing for its school reconstruction program. About $273 million in variable-rate debt was associated with the district's swaps, the report says.

When the world economy crashed last year, the risks the district ignored were exposed. In a series of investigative stories this year, The Morning Call showed that the district paid more than $25 million in fees to advisers and banks and made around $10 million in net swap payments.

If the district had used conventional fixed-rate financing instead of a variable-rate bond layered with two swaps on just one issue in 2003, the report says, Bethlehem taxpayers would have paid $10.2 million less. If it had used just the variable rate bond, the savings would have been even greater -- $15 million, it says.

The district had to terminate that 2003 deal in May at a cost of $12.3 million.

As a result of the district's bad gambles, the cost of paying for all the borrowing, interest, swap payments and fees sent the district's debt service payments "through the roof," Bethlehem's auditor, William H. Gorman, told Wagner's staff.

Even with a 5.1 percent tax increase this year, the school board over the summer was forced to cut millions of dollars out of the budget, ending programs for at-risk students and laying off dozens of staff.

Wagner's office said that since other swaps are still in place, it couldn't assess how beneficial or damaging they would be to taxpayers. Regardless, the report concludes that even if the swaps were to work in taxpayers' favor, the risk outweighs the benefits.

Wagner commended Boscola and The Morning Call, saying the investigative series prompted Boscola's demand for an independent investigation.

The auditor general said the school board bears ultimate responsibility for the decision to put taxpayer money at risk. Auditors interviewed 14 current or former members, seven of whom supported repealing or changing laws to bar local governments' use of swaps.

Bethlehem's former administrators, its former financial adviser and the investment banks it swapped with also share responsibility for the damage, the report says.

Former Superintendent Joseph A. Lewis, who stepped down in September, said he thought board members had adequate briefings on the deals when they were proposed, although he told auditors that fees to the advisers and banks were not disclosed. The district didn't appreciate the "inherent risk" in variable rate debt, he said.

In earlier interviews, Lewis claimed if the economy hadn't imploded, the district wouldn't have suffered financially.

"We do not regard this as an acceptable excuse," the report says, noting that a severe downturn was a risk the district ignored.

Lewis' top finance official, Stanley J. Majewski Jr., who also has since announced his retirement, said he may not have received enough information from outside advisers to make "appropriate decisions."

Majewski "was unaware that the district may have been the only school district in Pennsylvania that paid a "structuring agent fee"' for the swaps, the report says. The district paid Access Financial Services of Lancaster more than $1.8 million for swap structuring agent fees, according to state Department of Community and Economic Development records.

Further, Majewski, who had defended former financial adviser Les Bear in interviews with The Morning Call, told auditors he felt "betrayed" by Bear.

In one example highlighted in The Morning Call's investigative series, the school board in 2007 voted to terminate a swap, which would have made $600,000 for the district. The deal, however, wasn't terminated, which Majewski has said was because the market had turned against the district. Board members and Lewis said they were unaware the deal was not carried out.

Speaking to the state auditors, Majewski said Bear "was not entirely truthful" about whether the deal could have been terminated in the district's favor.

The report also criticizes "apparent" conflicts of interest in which Bear represented the district and the investment bank on the same deal.

According to the report, Bear declined to be interviewed because he was concerned his statements "might be taken out of context by the U.S. Securities and Exchange Commission in an investigation."

Federal authorities have been investigating the use of swaps by local governments since last year.

The report calls on state and federal law enforcement agencies to investigate possible conflicts of interest and to recover funds for taxpayers if they find wrongdoing.

Attempts to contact Bear on Wednesday at the offices of R.W. Baird, his current employer, were unsuccessful.

The report also has tough words for J.P. Morgan and Morgan Stanley, the investment banks that swapped with the district. It says they used "deceptive marketing tactics" to sell the idea of swaps to local governments.

"A school district, a public entity, is no match in terms of gambling with an investment bank," Wagner said.

The report notes the banks paid the fees to establish the transactions but didn't reveal they recouped those costs by increasing charges against the district. The deals brought "huge hidden profits that were not required to be, and have not been, disclosed to the district," it says.

The banks' "spread fees," which do not have to be disclosed, may have been up to three times the typical rate, the report says.

The fees charged by Bear and Access Financial also drew auditors' concern. Bear, the report says, was paid two to three times the going rate for his services. The structuring agent fees Access charged were unusual and excessive, it adds.

District officials, who publicly criticized The Morning Call series and after publication claimed the swaps saved taxpayer money, "quibbled with some of the numbers" in the report, Wagner said, but they didn't argue with its main premise. Auditors didn't necessarily agree with the district's financial revisions, but accepted them and incorporated them into the report.

The banks and advisers were aided by a state law unanimously passed in 2003 that was written for their benefit, not the taxpayers', the report says. Wagner and Boscola -- who were in the state Legislature at that time -- said the legislation was pitched as being in the best interests of local governments and approved with "virtually no discussion."

WHO TOOK OUT SWAPS

The Bethlehem Area School District isn't the only public entity in the region that financed projects with swaps.

State Auditor General Jack Wagner identified the 106 school districts and 86 municipalities and counties that entered into swap agreements between 2003-09. He did not say how much money was invested.